Securities: New York AG Sues Ernst and Young over Lehman Failure

The New York Attorney General last week filed suit against the international auditing firm Ernst and Young, alleging complicity in fraudulent accounting by Lehman Bros. prior to the collaps of that firm. The complaint alleges that the fraud allowed Lehman to hide its overly leverage balance sheet.

The case revolves around the accounting treatment of securities transactions known as "repo 105" transactions. The complaint alleges that the accounting treatment accorded the "repo 105" transactions allowed Lehman to park tens of billions of dollars in liquid fixed income securities with off shore banks. The State alleges that the sole purpose of the parking of these assets was to improve Lehman's balance sheet leverage when the company's financial reports were due.

A typical repo transaction is a financing arrangement that has no impact on a company's balance sheet leverage. However, the Financial Auditing Standards Board has determined, pursuant to FAS 140, that if a company gives up all control of a security and sells it at a discount ("haircut") of 5%, then the transaction may be booked as a sale rather than a financing arrangement. The theory of the rule is that the "haircut" will prevent the company from immediately buying the security back to create a wash transaction for the purpose if improving its financial statements. To book a final sale the company obtains a "true sale" legal opinion that the sale was a final transaction and not a cover for a financing arrangement. Such a final sale would improve the company's balance sheet leverage.

The Attorney General's complaint alleges that Lehman was unable to obtain a "true sale" legal opinion in the United States but did obtain one from a British law firm under local law for transactions in the United Kingdom.

In essence, the suit charges that E and Y entered a scheme with Lehman to help Lehman temporarily park securities to improve its balance sheet leverage. This concealed from third parties the precarious degree of leverage on Lehman's balance sheet. That leverage ultimately was a significant factor in the collapse of Lehman Bros.